The Dangers Of A High Yield

To investors looking for income, shares offering a high yield offer a double attraction.

First, of course, there's the higher than average income that the high yield offers. And second -- because yield increases as a share price goes down -- there's every prospect of a re-rating eventually bringing some capital appreciation.

I'm something of a High Yield Portfolio investor myself, as it happens. While a lot of my portfolio is tied up in index trackers and funds, most of the individual shares that I hold for the long term are high yield income plays.

Here be dragons

Of course, there's a danger to high-yielding shares: when is a high yield too high? When does that high yield, in short, indicate investor concerns about bad news lurking in the pipeline -- a dividend cut, a corporate banana skin, or fears about the long-time viability of the business or its profit margins?

Certainly, when you look at companies with yields that are far, far higher than average, it's not difficult to spot companies facing challenges. BP (LSE: BP), for instance, is currently offering one such yield at the moment, its share price driven down on fears of the costs incurred cleaning up (and stopping) the oil spill in the Gulf of Mexico.

Thanks, StepOne!

As it happens, back in June 2007, I spent two or three evenings analysing the FTSE 100's yields, using the excellent spreadsheet periodically posted by Fool reader StepOne.

My intention was simple: to see if I could determine at what point a high yield indicates a problem, rather than an opportunity offered by mis-pricing. At the time, you'll recall, the credit crunch had yet to hit (it was just weeks away), and Foolish high yield investors posting on the discussion boards were debating that very question.

Fifteen companies, it turned out, had a historic yield in excess of one standard deviation above the mean. And if that statistical language means nothing to you, translate the preceding sentence to read: 'fifteen companies had yields sufficiently high so as to be suspicious'.

Top of the flops

And here they are, in descending order of highest historic yield, with the share price in June 2007 compared with the price a couple of weeks ago -- 15 May, the date of StepOne's last high yield spreadsheet.

Note, in calculating the percentage rise or fall in the share price over the period, I've ignored the effect of rights issues, mergers and other dilutive corporate actions.

Danger sign

I think the table tells its own story. While the broader market is down, of course -- June 2007 marked the peak of the pre-credit crunch bull market, with the FTSE 100 closing at 6,732 on 15 June 2007 -- the number of companies that have since experienced serious adversity is worrying.

It's also instructive to look at the next five companies on the list: Rexam (LSE: REX), GlaxoSmithKline (LSE: GSK), HBOS, National Grid (LSE: NG), and Scottish and Newcastle, each of which hovered just below the cut-off point of one standard deviation.

Only two of those five have survived problem-free -- and of those two, National Grid has recently upset investors by announcing an unwelcome rights issue.

In short, a high yield can be an income investor's friend -- but also his enemy, unless other evaluation criteria, such as dividend cover, are carefully applied. And even then, problems can arise.